Is China the New France?
Imagine a country that grows its economy by greatly devaluing against the reserve currency to develop a strong export sector. As the country becomes a major world power, it accumulates massive amounts of the reserve currency, and fears grow that its actions could destabilize global markets.
If you think that description sounds like China today, you're right. But it also describes France in the 1920s. Lessons from that era are instructive for those seeking to forecast China’s long-term position in the world.
France faded and never regained the stature that it achieved in the 1920s. I’ll discuss whether China is headed toward a similar outcome. First, however, let’s look at the striking parallels between the two countries, including currency pegs, reserve accumulation and urbanization.
Currency-fueled export growth
Both China today and France in the 1920s devalued their currencies and later maintained a peg to the reserve currency – dollars and sterling, respectively. These actions created a global market for their exports.
When a currency is pegged, it does not trade freely on international markets. The foreign exchange rate of the pegged currency is fixed because its availability to settle transactions is very tightly regulated. James Rickards, author of Currency Wars: The Making of the Next Global Crisis, explains that for China, “The surest way to rapid, massive job creation was to become an export powerhouse. The currency peg was the means to this end.”
France employed this strategy to gain status globally in the 1920s, as an abundance of young men were returning from the war.It positioned itself to bolster its export sector in 1922 with currency devaluations. But within four years, the depreciation that drove its trade became too problematic, promptingPrime Minister Raymond Poincaré to step in and stabilize the franc. In an effort to address the domestic problems provoked by the weak currency and sustain growth in the export sector, the franc was pegged to the world reserve currency, the sterling.
Rickards’s account of China’s rise follows a very similar track. The modern Chinese economic miracle took off in 1978. The integration of a new market-oriented system at that time allowed China to start fueling its export sector by utilizing the massive labor force it had available. China concluded in 1997, based on multiple currency devaluations, that its best strategy was to peg the renminbi (RMB) to the world reserve currency, the American dollar.
Through export-driven growth, both nations established themselves on the world stage. France and China saw increased production in various industries, including the mining sector and textiles. Within a decade, France had tripled its total and consumer goods exports and quadrupled capital exports. China also reported striking statistics. In 2010, China held the title of the world’s largest exporter. In 2012, China reported approximately $2.05 trillion in exports.
These remarkable rises in exports led to dramatic growth in gross domestic product (GDP). Within a decade, both France and China were able to double their GDPs. Though the trade and industrial components of GDP saw the most progress, both countries also experienced some growth in agriculture.
A problematic accumulation of the reserve currency
A cheap currency and a strong export sector leads to a current account surplus and an accumulation of global reserves.
France and China undoubtedly had remarkable economic growth. However, they were unable to achieve it without accumulating foreign reserves. Following World War I, the United Kingdom pegged the sterling to its pre-war level. That rate did not account for massive wartime inflation, leaving the sterling overvalued (and the franc undervalued) for years. Additionally, when Poincaré stabilized the franc, the French government mandated that the Bank of France buy foreign currencies to avoid excessive appreciation.
Those two factors led France to accumulate a bulging portfolio of foreign currency. By 1928, France held half of the world’s volume of foreign reserves, which at the time was convertible to gold. But market instability grew as France sterilized the monetary impact of its accumulated gold reserves. That is, France effectively printed more francs in order to maintain its gold stock.
We can see parallels in China’s accumulation of foreign reserves. China’s pegged currency has essentially led it to outsource its monetary policy to the U.S. Federal Reserve. As the Fed has printed more currency, the People’s Bank of China (PBoC) has had to purchase dollars with newly printed RMB. As China sought to invest its newly acquired dollars safely and with a reasonable rate of return, it began purchasing massive quantities of U.S. Treasury obligations, which further aggravated China’s accumulation of foreign currency. As a result, China has found itself with $3.312 trillion of foreign exchange and gold.
Do China and France face similar fates?
Both nations accumulated global reserves in their respective eras, feeding worldwide concern over their influence on markets. The worries over France proved to be warranted, as the country’s foreign reserves accumulation was ultimately detrimental. As the value of the pound declined in 1930, the Bank of France was pushed into a no-win situation. France had to support the sterling, since liquidating its pounds would have prompted a sterling collapse.
Ultimately, France suffered a a huge exchange loss. When the British depreciated the sterling in September 1931, the Bank of France’s financial health deteriorated, as its dependency forced it into a precarious position. Ultimately, the Bank of France registered a capital loss of 2.35 billion francs on its sterling holdings, equal to twice the available capital and reserves.
As the franc lost value, the cost of imports rose and France faced inflation. By the end of the 1930s, patriotism in France was dwindling. Citizens underwent hardships amplified by government efforts to defend the franc and rebalance the budget. Since these massive losses, France has never truly been able to reestablish itself as a global world power.
Given that both China and France effectively accumulated global reserves in their respective eras, France’s experience prompts us to consider whether China will suffer a similar fate. Michael Pettis, a leading expert on China’s economy, argues that China will not follow France’s path. Pettis is a senior associate at Carnegie Endowment for International Peace and a finance professor at Peking University’s Guangua School of Management, where he specializes in Chinese financial markets. He is the author of the recently released and widely acclaimed book, The Great Rebalancing.
Pettis agrees that “China buys dollars, a floating currency, for the same reason that France bought sterling – to support its manufacturing sector.” But, he argues, “the undervalued RMB feeds into the domestic imbalances that Beijing is trying to reverse and so it must continue to rise.” Pettis explains that unlike France in the 1930s, China will not face a loss as the RMB gains value unless the U.S. acts to depreciate the purchasing power of the dollar – which Pettis does not expect to happen. He expects the value of China’s reserves to remain unchanged in terms of the country’s purchasing power abroad. (Foreign holdings can only be used to make purchases abroad.)
“There will of course be losses for the PBoC as the RMB appreciates, because all of its dollar reserves are funded by RMB borrowing,” Pettis concedes. But “these losses will be matched by an increase in the purchasing power of Chinese households.” Therefore, Pettis believes it is unlikely China will be pushed into the precarious position France faced. He explains that even if China did start to feel concerned about the value its dollars, it would be reluctant to reduce its foreign holdings because the value of the RMB would soar, severely hurting the country’s export sector.
Another parallel between the two nations is urbanization. As France grew in the 1920s, there was a notable increase in urbanization. But by late 1934, urbanization had begun to reverse. “Urbanization is almost always pro-cyclical,” according to Pettis. “It speeds up during times of growth and slows down or even reverses when the economy stops growing.” This same theory could certainly be applied to China, which has seen an increase in urbanization along with its export driven growth. Pettis stated that he “would be surprised if we did not see the same [reversal] happen in China.”
One of the main differences between these two nations is that China faces asset bubbles, particularly in real estate values. Pettis explained that until Poincaré stabilized the franc at 80% below its pre-war level, France faced substantial balance-of-payments pressures due to uncertainty and weakness in its economy. With high interest rates and a struggling economy, France was not susceptible to an asset bubble. In China, according to Pettis, the accumulation of foreign reserves is part of massive monetary expansion. Due to artificially low interest rates, an asset bubble was essentially inevitable.
The overall parallel between France and China holds true in that both nations devalued their currencies to build their export sectors. This allowed both countries to increase GDP, expand urbanization and accumulate more foreign reserves as they moved into internationally influential positions. But it is not a perfect parallel, given that differing global environments make it unlikely China will replicate France’s downfall.
Ultimately, France’s decline prior to the Great Depression was because its export sector could not generate continued economic growth, and its devalued currency led to high inflation and political unrest. China may someday face a crisis of slower growth and higher inflation, but it doesn’t today.
Marianne Brunet is an associate editor with Advisor Perspectives.